Taxpayer remains exposed, bank on it

Listening to politicians and central bankers arguing in favour of enhanced regulatory constraints on the banking sector, I’m never sure if they’re more concerned with achieving safer banking or avoiding the fiscal impost of a further financial bail-out. But they’re clearly not thinking improved intermediation.

On Wednesday, ahead of announcing his government’s blueprint for enhanced financial legislation, British Chancellor of the Exchequer
George Osborne
left little doubt he was after reforms that meant the taxpayer could avoid liability the next time the system turned sour. That’s going to be easier said than done.

He insisted London would continue to be a global banking hub – but from now on banks shouldn’t expect his government to underwrite their activities. Why? Because frankly, they can’t afford it. This meant, in future, “unsustainable borrowing in our banks must not lead to unsustainable borrowing by the government".

This suggests Britain is getting ready to introduce controversial bail-in arrangements, which would see a bank’s debt holders, not the government, bearing future losses through debt-to-equity conversion.

Unfortunately, this looks to be another of those great ideas in theory that has the capacity to go horribly wrong by making bank-debt issuance far more difficult and prohibitively more expensive.

It’s hardly surprising politicians have become so gun-shy about maintaining last-resort funding of the banking system. Buried in the latest European Central Bank’s Financial Stability Review is an assessment of the damage caused to euro zone government budgets by recent bank sector bailouts.

Between 2008 and 2010, government debt increased by 5 percentage points of euro zone gross domestic product, some €600 billion, with a further €800 billion of exposure provided in the form of contingent liabilities such as deposit guarantees. The Irish government was particularly badly hit, absorbing contingent liabilities equivalent to 125 per cent of GDP – or some €175 billion.

Ominously, the ECB review suggests this should be seen as a work in progress as this exposure could “increase further in the event of additional bank restructuring".

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Osborne surprised everyone with his early support for bail-ins and for moves to ring-fence core banking operations from the investment banking function. Most had expected him to wait until September, when the government-mandated Independent Commission on Banking releases its final report.

Instead, he’s decided to endorse the key recommendations of the interim report. This includes ring-fencing: rather than formally splitting banks into two stand-alone entities, the ICB report calls for the “subsidiarisation" of a bank’s businesses into two distinct entities retained under common ownership.

The trouble is, nobody’s really sure just how far this process might go, in terms of core and non-core. It’s been suggested that as much of two-thirds of British banking could still fall under the core banking banner. That would cover operations equivalent to some 300 per cent of Britain’s GDP. And given there’s a perception that this ring-fencing of traditional banking from investment banking will imply a more explicit government guarantee for the “safe" entity, this risks increasing the taxpayers’ contingent exposure to future crises.

One thing Osborne did avoid for now was supporting the commission’s call for British banks to face a minimum 10 per cent tier-one capital requirement.

This is some 3 per cent above the level recommended by the Basel Committee on Banking Supervision. But he did call on the European Union not to restrict sovereign flexibility in the rule-making process. He said it was vital “European rules give national regulators the discretion to add to the Basel requirements when national circumstances require it".

In January, when I first discussed the commission’s subsidiarisation proposals, I pointed to concerns raised by Standard Chartered chief executive Peter Sands. He felt ring-fencing would raise transaction costs, potentially even increase systemic risks and could have a negative impact on competition. Sands said anyone who thought subsidiarisation would ensure greater financial stability or easier resolution was “mistaken".

That’s just the unintended consequence JPMorgan Chase & Co chief executive officer Jamie Dimon had in mind last week when he asked US Federal Reserve chairman
Ben Bernanke
how much damage had been caused to economic activity by restricting bank intermediation through higher costs and over-regulation.

This week the United States Chamber of Commerce threw its not inconsiderable weight behind the Dimon push to get the Fed to reconsider plans to impose an additional capital impost on big banks.

Imposing such a “clear competitive disadvantage" on US banks risked raising the cost of capital for all businesses, creating a drag on economic growth, and endangering “the ability of the US economy to create the over 20 million jobs needed over the next 10 years", the chamber wrote in an open letter to Bernanke.

Intervention from such a respected industry lobby group was just what the debate needed.

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It’s a shame Reserve Bank of Australia governor
Glenn Stevens
doesn’t have the same faith in the Gillard government’s “balanced budget at any cost" approach as his Bank of England counterpart
Mervyn King
has in what the British government is undertaking.

King indicated on Wednesday that he saw “the mix of tight fiscal and loose monetary policy" as necessary for an effective rebalancing of the economy. Not so, says Stevens. He still favours strangling the domestic economy with higher rates – just in case.

King was in good form on Wednesday, using an Old Testament analogy to suggest we may be in the middle of seven particularly lean years economically, as an offset to the “seven years of plenty" experienced in the run-up to the global credit crisis.

But he had a strange justification for holding back on raising interest rates. He suggested the spreads between the bank rate and interest rates charged to borrowers “remain at unprecedentedly high levels, if indeed borrowers are able to access credit at all".

He reckons it’s unlikely these spreads would contract until conditions in the banking sector returned to something closer to normal. When it does, “the rate at which that takes place will have an important influence on the speed at which bank rates will rise".

Based on that logic, I can’t see British banks rushing to lower margins any time soon!